May 17 (Bloomberg) -- Gary Kain built American Capital
Agency Corp. into the fastest growing real estate investment
trust as the Federal Reserve pushed borrowing costs to record
lows. Now he’s trying to persuade investors to stay with him as
he navigates the central bank’s retreat.

American Capital has slumped 10 percent since May 2, the
worst performance in a Bloomberg index of 34 companies that
invest in mortgage bonds, after reporting an 8.6 percent drop in
book value from the prior quarter. Annaly Capital Management
Inc., the only mortgage REIT bigger than American Capital, said
its book value, a measure of its assets minus its liabilities,
fell 4 percent.

“The issue isn’t if the Fed exits, it’s a question of
whether they exit way earlier than expected,” Kain said in a
telephone interview. “We feel like positions are in much better
shape now than they were in the January-February time frame.”

Firms that buy government-backed home-loan bonds are under
pressure as investors speculate the Fed will withdraw from
buying $40 billion of mortgage securities each month as the
economy shows signs of strengthening. American Capital, which
increased assets over three years more than 20-fold to $100.5
billion at the end of 2012, plunged the most of mortgage REITs
after targeting higher-priced bonds that would benefit from
continued Fed intervention.

‘Wake-Up Call’

“The overall performance in the quarter, with decline in
book value, was a wake-up call that even very good managers like
Gary Kain with a great track record can’t bat a thousand all the
time,” said Steven Delaney, an analyst at JMP Securities LLC in
Atlanta.

Mortgage REITs have been among the biggest winners from
government policies to resuscitate housing and stimulate the
economy. The central bank’s policy of so-called quantitative
easing, purchasing Treasury and mortgage bonds, has made it
cheaper for REITs to borrow money to invest in the same
government-backed mortgage bonds the Fed has targeted.

That’s helped drive a 67 percent gain in mortgage REIT
stocks, including reinvested dividends, since the end of 2009,
with American Capital more than doubling. Now, with the housing
market rebounding and the unemployment rate declining in April
to 7.5 percent from a peak of 10 percent in 2009, speculation
has grown that the Fed will retreat earlier than anticipated.

Slowing Pace

San Francisco Fed President John Williams said yesterday
the central bank may begin slowing the pace of its bond
purchases as early as this summer, after three of the Fed’s
regional bank presidents called for phasing out the purchases.

“This is the year you should start thinking about reducing
exposure to the mortgage REITs,” said Daniel Furtado, an
analyst at Jefferies Group LLC. “There’s a tremendous amount of
price risk and the Fed has got its fingers all over
everything.”

The Bloomberg index of mortgage REITs has declined 3.6
percent this month. American Capital, gained 0.4 percent to
$29.65 today in New York.

Kain, the REIT’s president, joined Bethesda, Maryland-based
American Capital in 2009 after 20 years at Freddie Mac. He said
the firm is investing knowing that the Fed will disrupt markets
even though he disagrees with the likelihood of a midyear exit.

“The expected path is tapering over the next few months
and concluding around the end of the year,” Kain said in the
interview. “Mortgages should perform reasonably well under
those circumstances and they may do even better in that
scenario.”

‘Significant Weakness’

He told investors on a May 3 conference call that the
company had already recovered a portion of the first quarter
declines by the end of April, as economic reports signaled the
Fed would keep its program in place for longer.

He added that the “significant weakness in the prices of
specified mortgages has created an excellent opportunity to add
value-added product at attractive levels.”

Those specified pools contain mortgages that are considered
less likely to refinance, such as loans with low balances or
those given to borrowers who had already gone through the
Federal Home Affordable Refinance Program, or HARP, according to
Merrill Ross, an analyst with Baltimore-based Wunderlich
Securities Inc.

Mortgage bond investors monitor prepayment rates because
they influence returns. Bondholders risk losses when buying debt
for more than 100 cents on the dollar as the value can be erased
when homeowners take out new mortgages too early to repay
existing debt. As the government and Fed encouraged homeowners
to refinance, those types of bonds became more attractive to
firms like American Capital.

Paying Premiums

“They paid broker-dealers a premium for loans with
characteristics they thought would perform better, and now those
premiums are eroding because nobody else wants those bonds,”
Ross said. If the Fed retreats from the market, “those
specified pools aren’t as valuable because everything will slow
down,” she said.

Kain said the firm has purchased more at the reduced prices
because they can hedge the securities with derivatives so
they’re attractive even if interest rates rise.

“This is not a market for even mortgage experts like
ourselves to rely too heavily on any one opinion,” Kain said.
“It’s a time for making sure you have reasonable long-run
hedges in place and not go overboard in one direction or
another.”

On Tuesday, he rang the opening bell of the Nasdaq Stock
Market, a day after he bought 332,794 shares of the company,
almost doubling his stake in the REIT. The purchase was
scheduled, and Kain said he didn’t determine the timing.

‘Extremely Slow’

While investors are concerned about the Fed’s reduction in
bond purchases and the resulting risks they could create in the
market, the central bank probably will be “extremely slow” in
its withdrawal, said Michael Widner, an analyst at Keefe,
Bruyette & Woods. “That spells an environment that actually
gets better for the mortgage REITs before it gets worse.”

Even as Fed officials signal the scaling back of stimulus
efforts, signs are emerging of a slowdown in growth. More
Americans than projected filed claims for jobless benefits last
week and manufacturing in the Philadelphia region unexpectedly
shrank in May.

Options traders are the most bullish on American Capital in
three years, according to data compiled by Bloomberg. The
average dividend yield for mortgage REITs is 12.4 percent with
American Capital’s at 16.9 percent. Those that invest in so-called agency debt are trading at 0.93 times their book value,
Widner wrote in a May 15 report.

“We tend to see this kind of weakness in the group as a
buying opportunity, he wrote. ‘‘Fears the Fed is materially
closer to an exit are overdone, and when those fears are put to
rest (at least for a while) we see the group and MBS prices
bouncing back.’’